Thursday, January 12, 2006

An Externality Exercise

If actions I might take would provide benefits for other people which I am not in a position to charge them for, I have too little incentive to take them. If my actions would imposes costs on other people which I am not required to reimburse them for, I have too much incentive to take them. So let government subsidize or mandate the production of positive externalities, tax or ban the production of negative externalities, thus making us all better off.

There is a practical problem with this widely accepted argument for government interventions in the marketplace. One person's actions are quite likely to affect others in both directions--to impose both positive and negative externalities. Someone constructing an argument for a subsidy is likely to add up all the positive externalities and somehow miss the negative ones. Someone constructing an argument for banning something is likely to do it the other way around.

I first encountered this problem in my first piece of published economics. People worried about overpopulation argued that each additional child, by making the world more crowded, imposed costs on everyone else, and that it would therefore be a good thing if we all had fewer children.

Part of their argument was simply bad economics. A child does not come into the world with a deed to his per capita share of the world's resources clutched in his fist. To the extent that resources are privately owned, he gets them only if he, or his parents, offers something of at least equal value in exchange.

But not all relevant resources are privately owned. My child might pollute the air your child breathes. He might commit crimes against your child. He might use the political system to redistribute in his favor, at your child's cost. All of these are legimate negative externalities.

My child might also invent the cure for your child's disease, write a book that gives your child pleasure, help pay off the national debt, bear part of the burden of taxation for national defense, in any of a variety of ways make your child better off than if mine was not born. When I tried to add up negative and positive externalities, my conclusion was that I could not estimate them accurately enough to sign the result--to figure out whether, on average, the existence of my child made yours better or worse off, whether we should be taxing childbirth or subsidizing it.

The same problem arises in many other issues. Consider the case of schooling. Those who wish to justify our present system of public schools argue that educating children benefits everyone, and so should be paid for by the state.

I offer the following challenge to readers. List all the positive and negative externalities from educating children. For a second challenge, pick some other public policy commonly defended on externality grounds, and try to list the externalities with the wrong sign--the ones that are an argument for subsidizing what we now tax, or taxing what we now subsidize.

16 Comments:

Childbearing, just like education, is a way of perpetuating one's own behavioral patterns. From an evolutionary point of view, it is not a means to achieve something, but the very goal of existence. Those behavioral patterns, whether inherited or learnt, which fail to perpetuate themselves are bound to disappear.Thus, I disagree with the very notion that A is necessarily performing a service to B, if A takes care of the education of B's children. No -- A is perpetuating A's behavioral patterns, which may be different from those of B, in which case A reaps the benefit of B's investment. The government does not do its subjects a favor by providing education: it educates loyal taxpayers and tax collectors for its future self. It teaches "history" of its own liking, makes heroes of those who established, defended and extended the state, hoping that the example sticks, etc.Letting B teach A's children has a similar function to sex: giving up ceratain behavioral patterns in exchange for obtaining better chances of survival for the remaining ones. Sex with some people may be worth paying for, sex with others may require additional payment. The exact same holds for education, for identical reasons: some education is service worth paying for, some education is damage that must be compensated.In general, exchanging behavioral patterns, either via sex or via education, is beneficial. Being closed to outside infulences on the behavioral patterns of one's own children results in inbreeding.

It seems to me that sometimes the externalities are more clear than at other times. Take for instance childbearing.

I think it could be pretty easily argued that in highly overcrowded areas the costs outweigh the benefits. It's hard to be very contributing in China because so many of the resources go towards feeding and housing the populace. Thus the Chinese policies of discouraging childbirth, which I would argue have contributed in a big way China's burgeoning prosperity.

France, on the other hand, has a shrinking local population, an aging workforce, and various associated problems. Now the shoe is on the other foot, and childbearing subsidies seem to make sense. Well, or encouraging immigration, which probably makes more economic sense, but tell that to the French.

Anyway, my point is that there are situations that are sufficiently clear at the extremes that good arguments on balance could be made, even when the whole model is still intractably complex. Midwest corn subsidies come to mind.

According to the Economist pocket world in figures, Hong Kong's Pop. density is 6,511.6 per sq m. Singapore's is 6572.8. Netherlands is 385.3, Japan's is 337.5 (which understates the case: the majority of its land coverage is uninhabitable). I think it's safe to say that China's one child policy has certainly not contributed to its recent prosperity.

Is the question of whether Governments can do better than markets in any particular class of cases really just an empirical one (as your question seems to imply)? That would be a very inelegant state of affairs! Surely there exists some theoretical framework that enables us to answer the question at the level of principle?

How fascinating. Given the reversed balance of population density between Hong Kong and China, I think its obvious that China has to resort to population control because it has held the means of wealth generation from individual citizens.

This is a great natural experiment for those externalities: clearly they must exist on both sides of the balance, and it is possible for a government to set policy that removes negative externalities for a banned characteristic, thus "necessitating" the ban in the first place.

I have been thinking about this phenomenon for quite some time, but David expressed it better than my muddled musings.

At any rate, my earlier thoughts gave me a basic idea: what if government were to be rejiggered so that all policy required an independent survey of both positive and negative externalities, and a cost-benefit analysis based on these?

If such a survey of externalities were even just publicized, with government not necessarily required to act based on that information, it could still go a long way towards eliminating bad legislation (i.e. most of it).

This process could somehow integrate a "public comment period", to survey externalities, "poll" public opinion, and solicit summary judgements. This could all be very effective in today's atmosphere of collaborative media.

Public schools are all negative as far as I am concerned (especially now that I have graduated and have no children of my own):

1. I get taxed out the wazoo to pay for the schools.2. I am daily inconvenienced by school buses that hog the road and make me wait while parents install their offspring in the seats.3. The schools throw kids together into age cohorts that influence one another badly to engage in antisocial behaviors rather than thinking themselves part of a wider community of all ages.4. The schools produce, at best, authoritarians who grow up to support an even bigger state.5. The schools tend to keep teenagers out of the labor market so I have to pay more to get my lawn mowed/leaves raked/dogs walked.

And the positives are overstated in my view. I don't benefit at all. Parents derive almost 100% of the benefits. And most parents would find a way to educate their children on their own dime if free schools weren't provided; therefore, the choice is not between school and no school, but between subsidized and unsibsidized school.

I am perplext by all this discussion that equates schooling and education. I work for a school reform organization (!) and it seems very clear to me that the real, practical, and taboo-to-state purposes of state sponsored "schooling" are (1) to provide subsidized day-care to a middle class which can no longer afford the care of its own children, and (2) to manufacture an artificial worker scarcity by removing young workers from the workforce.

While these points do not change David's original point about externalities, if one wishes to discuss the politics, policies, and economics of our system of government schooling in the US, these are the realities one must address. I say this as a sympathetic fellow-supporter of the separation of school and state, but one who has discovered that the very best arguments concerning education, free speech, economics, etc. all break like waves upon those hidden rocks.

For a second challenge, pick some other public policy commonly defended on externality grounds, and try to list the externalities with the wrong sign--the ones that are an argument for subsidizing what we now tax, or taxing what we now subsidize.

The estate tax comes immediately to mind. It is defended on the grounds that concentration of wealth leads to laziness, concentrated power, and . . . general snobishness for generations to come.

In reality, the estate tax, like any other wealth tax, discourages something that should be subsidized: creation of income and thriftiness.

We should replace it with a tax credit (reaped by your heirs) for every dollar you die with.

"In reality, the estate tax, like any other wealth tax, discourages something that should be subsidized: creation of income and thriftiness.

We should replace it with a tax credit (reaped by your heirs) for every dollar you die with."

For a given level of expenditure, a tax credit means that some other tax will be higher, and hence have more tendency to distort behavior.

Further, your proposal creates an incentive to leave money to your heirs instead of spending it yourself, donating it to charity, giving it to people while alive, or whatever the other alternatives might be. Why do you want to do that?

. . . your proposal creates an incentive to leave money to your heirs instead of spending it yourself, donating it to charity, giving it to people while alive, or whatever the other alternatives might be. Why do you want to do that?

Because if there's one thing America's lacking, it's some good, solid oligarchy.

But let me take one more stab: the progressive income tax. It discourages people from attaining (i.e. producing) increasingly higher levels of wealth. And all things being equal, another person's drive to produce more wealth has net positive effects for the rest of us.

So the efficient (but one might say heartless) way to deal with this is the opposite: a regressive income tax. Tax the poor more, and you'll have that much less incentive to remain poor and correspondingly more incentive to engage in societally useful wealth creation.

"So the efficient (but one might say heartless) way to deal with this is the opposite: a regressive income tax. Tax the poor more, and you'll have that much less incentive to remain poor and correspondingly more incentive to engage in societally useful wealth creation."

This is an issue that has been dealt with at some length in the economics literature, and trying to work it out verbally for yourself is a bit risky. To begin with, what we want isn't an incentive but the right incentive--"societally useful wealth creation" isn't some infinitely valuable objective that we want people to bear any possible cost to achieve.

You can find a sketch of part of the conventional argument in a book chapter of mine webbed at:

From an incentive standpoint, the standard view is that a head tax is optimal, since the marginal rate is zero for everyone--but you can't collect it if the amount of the tax is more than the income of the poorest individual, and most people regard it as an unfair allocation of the burden of government.